Credit Default Swaps: Financial Markets, Corporate Finance and - PowerPoint PPT Presentation

Credit Default Swaps: Financial Markets, Corporate Finance and Regulation Ma Marti G. i G. Subrahmanyam Edwa ward A Altman L Lecture Warsaw C w Confer eren ence i in F Finance 2 e 2018 Szkoła Główna Handlowa w Warszawie April 12, 2018

Credit Default Swaps: Financial Markets, Corporate Finance and Regulation Outline o Definition of Credit Default Swaps (CDS) o Views of policy makers and business leaders o CDS market structure and regulation o CDS pricing o CDS, bond and equity markets o CDS and corporate finance o CDs and financial intermediaries o Sovereign CDS o CDS indices 2

Credit Default Swaps: Financial Markets, Corporate Finance and Regulation Definition of Credit Default Swaps (CDS) o Credit derivatives: instruments whose payoffs are related to credit events o Basic product categories: replication, event-triggered and embedded o CDS: event-triggered similar to insurance contracts o Definition:  the buyer of protection pays a constant premium per year, d bps, until the maturity of the contract OR the occurrence of the default event (whichever comes first)  the seller pays • if the default event does occur : the difference between the promised (face) value of the underlying issue ( 100 ) and the market value of the defaulted bond ( Y ) • if the default event does not occur : zero 3

Credit Default Swaps: Financial Markets, Corporate Finance and Regulation d bps p.a Protection Protection If credit event: Par Buyer Seller If credit event: Deliverable Obligation  if no default : only cash flow is premium of d bps p.a  if default : transaction stops and transaction settled either physically or in cash: physical : buyer delivers defaulted obligation to seller and seller delivers • 100% of nominal to buyer. (Physical is market standard) cash : Mechanism to establish (“final price”) and seller delivers notional of • transaction x (100 – Final Price) to buyer 4

Credit Default Swaps: Financial Markets, Corporate Finance and Regulation Basic Structure Bilateral Contract o One entity pays a fee, usually each period o One entity makes a payment contingent upon the occurrence of a credit-related o event of a third party Fee: basis points based on a notional amount o Contingency: o  Bankruptcy, insolvency, failure to make a payment when due, restructuring etc.  Price decline in a reference security (e.g., bonds of the third party) Reference security: bonds issued by sovereigns, agencies, financial institutions, o corporations, indices, etc. Default event: has to be defined clearly and precisely: ISDA o 5

Credit Default Swaps: Financial Markets, Corporate Finance and Regulation Definition of Default Event o Full Restructuring (CR) o Modified Restructuring (MR) – only obligations with maturities of less than 30 months of event date can be delivered o Modified-Modified Restructuring (MMR) – only obligations with maturities of less than 30 months of event date can be delivered, but of less than 60 months for restructured obligations o No Restructuring (XR) – excludes Restructuring as a credit event 6

Credit Default Swaps: Financial Markets, Corporate Finance and Regulation Conflicting views on benefits of CDS contracts: Alan Greenspan, Fed Chairman “The new instruments of risk dispersion have enabled the largest and most sophisticated banks in their credit-granting role to divest themselves of much credit risk by passing it to institutions with far less leverage . These increasingly complex financial instruments have contributed, especially over the recent stressful period, to the development of a far more flexible, efficient, and hence resilient financial system than existed just a quarter-century ago. ” Alan Greenspan's speech ``Economic Flexibility" before Her Majesty's Treasury Enterprise Conference (London, 26 January 2004). 7

Credit Default Swaps: Financial Markets, Corporate Finance and Regulation Conflicting views on benefits of CDS contracts: Warren Buffett, Berkshire Hathaway “I view derivatives as time bombs , both for the parties that deal in them and the economic system. I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers , who in addition trade extensively with one other. The troubles of one could quickly infect the others. In my view, derivatives are financial weapons of mass destruction , carrying dangers that, while now latent, are potentially lethal.” Warren Buffet in the Berkshire Hathaway annual report for 2002 8

Credit Default Swaps: Financial Markets, Corporate Finance and Regulation Importance of CDS: o Vast academic literature: 600+ papers o Legal and institutional changes o Major impact on global economies, e.g., Greece, Argentina, Venezuela etc. o Important topic for financial market professionals, corporate financial managers, regulators and policy-makers 9

Road Map o CDS market structure and regulation o CDS pricing o CDS, bond and equity markets o CDS and corporate finance o CDS market structure and regulation o CDs and financial intermediaries o Sovereign CDS o CDS indices

Credit Default Swaps: Financial Markets, Corporate Finance and Regulation CDS Market Structure and Regulation: Timeline 11

Credit Default Swaps: Financial Markets, Corporate Finance and Regulation CDS Market Structure and Regulation: Significant Market Developments o CDS invented by JP Morgan in 1992-1994 o Trade body: International Swaps and Derivatives Association o CDS growth and liquidity primarily boosted by its standardization through the ISDA “Master Agreement” “ISDA Credit Derivatives Definitions” o Explosive growth until 2007 and sharp contraction during the crisis:  CDS Notional Amount Outstanding in Q1-2001: 631.5 billion USD.  CDS Notional Amount Outstanding in Q2-2007: 62.173 trillion USD.  CDS Notional Amount Outstanding in Q2-2010: 30.261 trillion USD.  CDS Notional Amount Outstanding in Q2-2014: 19.462 trillion USD. o Institutional changes with CDS Big Bang in the U.S.CDS Small Bang in Europe o “Naked CDS Ban” implemented by the European Commission in December 2012 o Future landscape will be significantly altered by outcome of Volcker rule and Dodd- Frank Act in the US and EMIR and MiFid II in Europe 12

Credit Default Swaps: Financial Markets, Corporate Finance and Regulation CDS Pricing: Concepts and Practical Issues o Theoretical equivalence of credit spreads and CDS spreads by arguments of no- arbitrage o CDS spreads similar to a ”spread on a floater” (par bond CS), i.e. long FRN and short a default-free bond o Reasons why the relationship may not hold:  Benchmark curve for credit spreads: Swap curve vs. Treasury curve  Contract specifications: Restructuring clause and CTD option (inflates CDS)  Market Efficiency and Price Discovery  Liquidity premia: bonds less liquid than CDS  Short sale restrictions on bonds and Repo costs (depresses CS)  Specialness and tax effects  Differences in counterparty risk  Recovery risk may be priced differently in the two markets 13

Credit Default Swaps: Financial Markets, Corporate Finance and Regulation My Paper on CDS Pricing: o Nashikkar, Subrahmanyam and Mahanti ( JFQA 2011 ) o Objective: Investigate the interaction between market liquidity and the price of credit risk o Key Results:  Bonds with higher latent liquidity are more expensive relative to their CDS contracts (after controlling for other realized measures of liquidity)  Highly illiquid bonds of firms with a greater degree of uncertainty are also expensive, consistent with limits to arbitrage between CDS and bond markets, due to the higher costs of “shorting” illiquid bonds  Positive effects of liquidity in the CDS market on the CDS -bond basis  Several firm - and bond- level variables related to credit risk affect the basis. The CDS spread does not fully capture the credit risk of the bond 14

Credit Default Swaps: Financial Markets, Corporate Finance and Regulation CDS, Bond and Equity Markets o Acharya and Johnson ( JFE 2007) o Debate on whether information flows from equity to CDS market or vice -versa o CDS returns lead equity returns for lower rated companies, large credit spread moves o CDS are negatively correlated with future stock returns only for the large distressed companies in the sample. 15

Credit Default Swaps: Financial Markets, Corporate Finance and Regulation CDS and Corporate Finance CDS is a tool for credit risk transfer and allows shorting of credit: Detaches the economic interest from the voting power of creditors o Has the potential to change the behavior of lenders and borrowers o Permits the creation of “empty creditors”! o  Hu and Black (European Financial Management, 2008)  Empty creditors: creditors whose exposures are hedged (or even over-hedged) with CDS while nominally they are still lenders (unobservable)  Positions and trades unobservable to other agents and borrowers Changes the debtor-creditor landscape significantly o  Affect the monitoring incentive Empty creditor: Ex ante commitment benefit; Ex post tougher negotiator o Empty creditor problem and corporate finance o  Credit supply  Restructuring and bankruptcy  Corporate financial policy 16